By A.Tatum & J.Mosbacher | October 3, 2013

Report

Executive Summary

In September 2013, the California State Legislature began a four-month recess, once again leaving one of the state’s most significant and escalating issues unresolved – the major California State Teachers’ Retirement System’s (CalSTRS) funding shortfall. Until now, failing to address the shortfall has delayed some short-term budget strains but ironically made California’s K-12 education system far more vulnerable to severe cuts in both the near and long-term future.

CalSTRS requires significant contribution increases to make up a $71 billion shortfall and pay for current and future benefits.So far the least expensive solution will cost an additional $4.5 billion in 2014 and total $240 billion over the next 30 years

Like many public pension funds, CalSTRS is fiscally distressed because its investments underperformed and it remained perpetually underfunded. Consequently, CalSTRS requires significant contribution increases to make up a $71 billion shortfall and pay for current and future benefits. In California, the state Legislature is responsible for approving the contribution levels.

The least expensive long-term solution CalSTRS proposes is for the state, school districts and/or program members to contribute more to the system, starting with an additional $4.5 billion in 2015 and totaling $240 billion over the next 30 years. Though the least expensive solution, this is nearly twice what the state, districts, and members currently contribute, presenting a clear funding challenge that school districts and state department budgets will likely bear going forward.

Even the hefty $240 billion funding estimate may be overly optimistic. First, it assumes that CalSTRS will earn a 7.5% average rate of return on its investments over the next 30 years, a target CalSTRS missed over the last decade and one that the system’s consulting actuaries predict it will likely miss over the next three decades. Furthermore, it assumes that the Legislature will act within the next year. CalSTRS has required increased contributions since 2003, but the Legislature has consistently avoided implementing a funding solution. Given the body’s continued inaction and seeming apathy toward the problem, pursuing a solution within the next year appears increasingly unlikely.

Waiting comes at a price. The longer the Legislature delays action, the more expensive the solution becomes. At current contribution levels and assumptions, the unfunded pension debt will grow by an average of $50 million each day for the next 30 years. At this pace, the plan will run out of assets in 2043, making the out-of-pocket annual cost of providing these legally guaranteed benefits enormous.

Rectifying CalSTRS’s funding shortfall will not be an easy endeavor. Diverting $4.5 billion from schools is the equivalent of eliminating statewide spending on K-12 books and supplies – twice. It is also more than the state spends on courts and on roads, and nearly as much as the state spends on the University of California and California State University systems combined. Having waited this long, fixing CalSTRS now will be difficult and painful. But should the Legislature wait much longer, fixing CalSTRS will mean devastating our schools and services in the process.

Key Findings

In this report, we first provide a general background on the CalSTRS plan and what caused its massive funding shortfall. We then outline the financials associated with restoring the plan to full funding and illustrate the costs of further delay. Our findings include the following:

The system requires $240 billion, not $135 billion.Commentators have repeatedly pegged CalSTRS’s funding requirement at $135 billion ($4.5 billion x 30 years). In actuality, to fully fund the plan over the next 30 years, CalSTRS contributions need to increase by 15.6% of payroll, or $4.5 billion in 2015 initially.1 As payroll grows, so too will the annual payments, working out to $240 billion in additional contributions between 2015 and 2044, 80% more than the total contributions under current funding levels.

Poor investment performance and benefit increases drove the funding shortfall.From 2000-01 to 2011-12, CalSTRS’s investments averaged a 3.8% annual rate of return, half of the current expected rate of 7.5%. Still, had the Legislature not increased benefits in 2000, even if CalSTRS’s investments had still underperformed, its funding ratio would be 88.4% today, making it one of the nation’s best-funded public pension plans.

Annual investment returns would have to exceed 10%. Since 2003, CalSTRS has required larger contributions. Investment returns would have to average over 10% for the next 30 years for the plan to reach full funding without larger contributions – a highly unlikely scenario. If the plan earns only a 5.1% average annual rate of return, the required $240 billion jumps to $580 billion.

Contribution delays will increase long-term costs. Each year the Legislature delays contribution increases, the more expensive funding the plan becomes. If left unaddressed, the unfunded pension obligation will grow by an average of $50 million each day and reach $617 billion by 2043 or possibly sooner if investments continue to underperform.

Background: California State Teachers’ Retirement System

Established in 1913, the California State Teachers’ Retirement System (CalSTRS) provides retirement, disability, and survivor benefits to academic personnel in California’s public education system (pre-kindergarten through community college). With 862,192 members and approximately $144.2 billion in assets as of June 30, 2012,2 CalSTRS is the nation’s second largest public pension fund.3 It provides benefits to teachers, faculty, counselors, administrators, librarians, and their families. Among CalSTRS members, 49% are active members still earning benefits, 21% are inactive members who are not working but have earned benefits, and 30% are retired members and beneficiaries who are currently receiving benefits.4

CalSTRS provides a monthly pension payment in an amount based on the retiring member’s years of service, age at retirement, and final compensation. Members do not receive Social Security benefits and often rely primarily on the pension benefit for retirement income.5 As of June 30, 2012, the average benefit for a retired CalSTRS member was $42,204 per year ($3,517 per month), or 67% of final average compensation. This is up from $15,564 per year ($1,297 a month), or 54% of final average compensation two decades ago.6

To help fund these benefits, the state, program members, and school districts all contribute set percentages of payroll into a common trust fund. CalSTRS collects and invests these contributions during each member’s career. Upon an member’s retirement, the contributions and investment earnings cover the cost of the benefits that the member has earned over the course of his or her career.

Because laws guarantee and protect benefits earned by members, trust fund assets are supposed to be sufficient to cover the full cost of benefits provided decades into the future. To help measure the progress toward full-funding, CalSTRS contracts with actuaries who estimate the cost of benefits in future years by estimating future years worked, retirement ages, salary growth, and life expectancies. This sum is converted to a present day value that is spread over the working career of each member.

The buildup of this running total comprises a pension debt, called the Actuarial Obligation, which essentially provides a point-in-time measurement of the amount of assets the plan should have saved up to pay future benefits. As of June 30, 2012, the obligation was $215 billion but accumulated assets were only $144 billion, meaning that only 67% of this obligation is funded (this is called the funding ratio) (Table 1). To ensure that the plan can fund the benefits promised to its members, plan contributions will need to increase to pay off the $71 billion that remains unfunded.

The CalSTRS Funding Shortfall

The last time the funding ratio was this low was in 1987 when the plan was experiencing large investment returns and was well on its way to being fully funded.8 However, a funding ratio only provides a point-in-time measurement of a pension plan’s financial health. It is more important to examine the funding ratio’s long-term trend and consider its financial sustainability going forward.

In 2000, CalSTRS had a surplus of assets compared to its obligations, corresponding to a 110% funding ratio (Figure 1). Since then, the funding ratio has declined steadily, falling to 67% in 2012. Worse yet, this downward slide will continue into the future: given current contribution levels, obligation growth, and projected investment performance, CalSTRS estimates that its fund will run out of assets by as early as 2043. In this scenario, CalSTRS would no longer have any assets to provide benefits previously earned by members.

Because invested assets compound annually, funding shortfalls experience a snowball effect – the disparity between assets and obligations grows each year the debts remain outstanding.

One of the principal causes of CalSTRS’s funding shortfall is a decade of lower than assumed investment returns. Over the past 20 years, investment returns have accounted for 60% of all plan revenue.10 When investment returns fall short of expectations, the fund requires increased contributions to cover the decline in investment revenue and avoid an overall funding shortfall. Furthermore, because invested assets compound annually, funding shortfalls experience a snowball effect – the disparity between assets and obligations grows each year the debts remain outstanding.

Between 1995 and 2009, the CalSTRS board assumed that the fund’s investments would achieve an 8% annual rate of return before reducing that rate to 7.75% in 2010 and then 7.5% in 2011.11 Indeed, had investment returns met this expectation, CalSTRS would be more than 100% funded today.12 However, annual investment returns from its 2000-01 funding ratio peak through 2011-2012 fell far short of these assumptions, averaging just 3.8%.13 The greatest single-year shortfall occurred in 2009, when CalSTRS’s investments lost over one-quarter of all of the plan’s assets.14 Because investment returns fell short of assumptions, the revenue accumulated in the trust fund was not able to match the growth in pension debt.

While lower than expected investment returns are the main cause of CalSTRS’s problems, increased member benefits are another important contributor to the funding shortfall. In reaction to the system’s enormous investment returns in the 1990s and the brief resulting surplus, the state Legislature assumed that these investment trends would continue and increased the benefits it provided to members.15 Had the stock market boom sustained itself over the next decade, contribution levels would have been sufficient to cover these benefit increases. However, the stock market boom proved unsustainable, and corresponding contribution levels were insufficient to fund the increased benefits. Had the Legislature not increased benefits, even if CalSTRS’s investments had still underperformed, the funding ratio would currently be 88.4%, thereby making CalSTRS one of the nation’s best-funded public pension plans.16

Funding the Pension Shortfall

Current CalSTRS contribution levels are insufficient to pay off even the annual interest on the system’s unfunded pension obligation, let alone to make up its entire funding shortfall. For instance, the interest charge on CalSTRS’s unfunded pension obligation is $5.3 billion for 2013, and contributions are only $5.1 billion.17 Unless higher rates of return on CalSTRS’s investments account for the difference (a highly unlikely scenario, as we will explain), the Legislature must raise contributions instead.

The plan receives contributions that are calculated as a percentage of member payroll, and current contributions levels are set at 19.47%.18 To fully fund the plan over the next 30 years, Milliman – the actuarial firm hired directly by CalSTRS – projects that the fund requires an additional 14.62% of member payroll starting in 2013 – an initial contribution increase of $3.9 billion.19

However, the Legislature made no such contributions in the last fiscal year (2012-13) and has not budgeted them for the current fiscal year (2013-14). The longer the Legislature waits to increase contributions, the higher those contributions will ultimately have to be increased. At current contribution levels and assumptions, the unfunded pension obligation will grow by an average of $50 million each day for the next 30 years.20 Increased contributions are unlikely to begin before 2015, at which point, the contribution requirement rises to 15.6% of payroll, or $4.5 billion initially.21 This equates to an additional $240 billion that needs to be paid into CalSTRS between 2015 and 2044, 80% more than the total contributions under current funding levels (Figure 2).22

It is likely that actual contributions will need to be higher than even the $240 billion indicated in Figure 2. The plan’s officially reported pension obligation does not fully reflect the actual value of future pension payments, but rather, their cost under its assumed rate of return on future investments. When calculating the value of its future assets and obligations, CalSTRS assumes that it will generate a 7.5% annual average investment return.

According to the Milliman Experience Analysis, investments will most likely average less than this rate over the next 30 years.23 To the extent that this return assumption is not met, the actual funding status of the plan will be lower and the contributions necessary to fully fund it will increase. For example, if CalSTRS’s trust fund averages a 5.1% investment return rate, contributions would have to increase by $11 billion initially and by approximately $580 billion from 2015 to 2044 to fully fund the plan in those 30 years, more than twice the current estimate of required funding (Figure 3).24

Conversely, if investment performance exceeds 7.5%, the fund will require smaller contribution increases. For example, if CalSTRS earns an 8.5% return over the next 30 years, contributions will instead need to be increased to $2.4 billion initially and by approximately $130 billion from 2015 to 2044 in order to fully fund the plan, nearly half the current estimate of required funding.25

For the 2013 fiscal year, CalSTRS earned a 13% rate of return on its investments.26 While this is certainly helpful for the fund’s financial health, CalSTRS would have to earn 10% annuallyover the next thirty years to make up for its current funding shortfall (without increased contributions).27 Given that investment returns will most likely not even meet the assumed rate over the next 30 years, this is a nearly impossible scenario.

Where Will the Money Come From?

Legally, the state is obligated to provide benefits it has guaranteed current and future retirees. The state Legislature clearly needs to increase contributions to cover the funding shortfall and stabilize CalSTRS. The sources of this extra funding, however, remain uncertain. In principle, the increased contributions can come from only three different sources: the state, school districts, and/or plan members themselves.

Plan members currently direct 8% of their payroll into CalSTRS, and school districts contribute an additional 8.25% (Table 2). The state’s contribution varies, but over the next 30 years, it is estimated to average 3.22% of payroll.29

It is unlikely that the Legislature will significantly increase contributions from current members. According to CalSTRS, the only means by which the current member contribution rate can be increased is to provide the member with an increased benefit of comparable value.31 However, CalSTRS has indicated that there is a benefit provision which will allow for a small ongoing current member contribution rate hike of 2.6%. Furthermore, future members are not exempt from increased contribution rates.32

It appears likely that the bulk of the contribution increases will come from the school districts and/or the state, without a clear indication of how the payment will be split. Determining this split is complicated and highly uncertain largely due to Proposition 98 (1988), which requires a minimum percentage of the state budget to be spent on K-14 education.33 If school districts are required to increase their contribution to CalSTRS, there is some debate as to whether or not the state will be obligated to provide an offsetting increase in Proposition 98 funding.34

In 2006, the legislative counsel opined that the state would indeed have to provide an offsetting increase in Proposition 98 funding if the school districts were required to contribute more to CalSTRS.35 However, in the same year, then Attorney General Bill Lockyer disagreed, and opined that the state would not have to provide offsetting Proposition 98 funding, implying that school districts would have to absorb the contribution increase using their existing resources.36 It is possible that policymakers will turn to the courts for a decision on this issue before implementing a CalSTRS contribution rate increase.37

CalSTRS Contribution Hikes Will Likely Hurt Schools

An initial $4.5 billion increase in CalSTRS contributions, an amount which will continue to grow 3.75% for the next 30 years, will raise significant cash flow concerns. This increase alone will more than double what the state and school districts currently pay into the CalSTRS defined benefit program ($3.5 billion in 2015). It is also more than twice what districts spend on books and supplies statewide, more than the state spends on courts and on roads, and nearly as much as the state spends on the University of California and California State University systems combined. 38 Thus fully funding CalSTRS is no easy endeavor.

Regardless of the decision regarding the Proposition 98 funding issue discussed earlier, an increase in CalSTRS contributions will likely be felt by the school districts even if the state ultimately pays for it. According to Fitch Ratings, “…school districts will pay either directly bytaking on increased contribution rates without offsetting funding or indirectly through reduced state funding or other methods.”39

Directly or indirectly diverting $4.5 billion from the budgets of California’s school districts would inevitably crowd out other areas of school spending. For example, the initial annual increase of $4.5 billion is equal to 9% of 2012 school district General Fund expenditures.40 Of General Fund spending, approximately 21% is already dedicated to teacher and staff benefits, while the remaining pays for teacher and staff salaries (63%), services and operations (10%), books and supplies (4%), and construction and transfers (3%).41

Figure 4: Where does an Increase in CalSTRS Contributions Fit in the K-12 Budget?42

Thus directly or indirectly diverting $4.5 billion to higher benefit spending will either force cuts to salaries, necessitating a decrease in faculty and staff size, or will crowd out spending for books, supplies, and other non-benefit spending. This large contribution increase would place significant strain on already struggling districts. For example, the California student-teacher ratio (26:1) is already the nation’s worst.43 Increasing benefit spending would greatly magnify the existing trend of teacher and staff benefits consuming larger portions of school district spending. In 2004, benefits accounted for 18% of school district spending, and in 2012, this grew to 21% (Figure 4).

There may be some temporary assistance from November 2012’s Proposition 30, which temporarily increased California’s personal income tax revenue. Proposition 30 passed largely based on assurances that the state would direct a large portion of its added tax revenue to schools. The California Legislative Analyst’s Office projects that in 2015, Proposition 30 tax revenue will bring in an additional $6.1 billion for the state, some of which schools must receive under Proposition 98.44 This looming $4.5 billion in additional pension costs would consume the majority of the Proposition 30 tax revenue and fund retirement benefits rather than classrooms directly. However, school districts cannot rely on Proposition 30 tax revenue over the long-term because it expires in 2019.

It is important to recognize that a CalSTRS contribution increase would join contribution increases that the state’s other financially-troubled retirement benefit plans require. For example, the state employee pension system and the state retiree health care system have unfunded obligations of $39 billion and $64 billion, respectively, and now also require significantly higher contributions to make up for their funding shortfalls.45

Due to the magnitude of the required contribution increases and current budgetary constraints, it is perhaps more likely that the Legislature will decide to phase-in the contribution increases and/or pay off the debt over a longer period of time. This approach may help ease the transition into full funding. In February 2013, CalSTRS sent a report to the state Legislature outlining various funding scenarios. These scenarios differ based on start date, funding target, length of phase-in period, and the debt pay-off period.46 However, all of these alternate scenarios essentially delay the inevitable and defer higher costs to future taxpayers. It is difficult to speculate which funding plan the Legislature will ultimately approve (if and when it actually approves a funding plan). At this point, however, the cheapest proposed long-term scenario is to contribute an additional 15.6% of payroll (or $240 billion) over the next 30 years.

The $240 billion funding solution referred to in this report assumes that the Legislature will act on the issue before the next fiscal year, which is becoming increasingly doubtful. By delaying a decision, the Legislature is essentially raising the cost of funding the plan while further threatening the futures of California’s school districts. Because investment returns make up the overwhelming majority of CalSTRS’s revenue, it is optimal to fully fund the plan as soon as possible.

The increased contributions would help pay off the unfunded pension obligation, which grows with interest each year it is not paid. At current contribution levels and assumptions, the unfunded obligation will grow by an average of $50 million each day over the next 30 years.

As of June 30, 2012, CalSTRS’s unfunded obligation was $71 billion. Should the Legislature decide to wait until 2015 to begin addressing the issue, it will be faced with an $88 billion unfunded obligation (Figure 5). In 2020, this obligation will grow to $129 billion and in 2030 it will swell to $256 billion. If the Legislature declines to increase contributions into the plan, the plan will be depleted of all its assets in 2043, while also having a $617 billion (and growing) unfunded pension obligation still outstanding. The plan will run out of assets even sooner if investments continue to underperform.

Even if CalSTRS runs out of assets, members still have a contractual right to their benefits. Therefore, the state and school districts would have to directly provide these benefits from somewhere in their operating budgets – a highly inefficient option called “pay-as-you-go.” At that point, benefit payments would be significantly more expensive because investment returns – which fund 60% of annual benefit payments – would no longer be a revenue source. The state and school districts would be forced to make up this loss in revenue from elsewhere in their budget indefinitely, likely leading to a massive crowding out of other services. As stated earlier, it is likely that school districts will suffer the most from such an outcome, which places the future of California’s education system in jeopardy.

Whether or not the Legislature increases contribution levels into CalSTRS, the cost of providing benefits to plan members will inevitably go up. Starting now is simply the cheapest and most responsible route.

Recommendations

To better ensure CalSTRS’s financial health, the Legislature should regularly and systematically review contribution levels for adequacy, and should always set contributions at levels necessary to fully fund the plan.49

Current contribution levels are inadequate. The Legislature must increase them immediately from some combination of members, school districts, and the state to levels that are sufficient to fully fund the plan. The longer the Legislature waits, the more expensive the cost of providing benefits becomes and the greater the threat such costs pose on the state and its school districts. We recognize that increasing contributions by $4.5 billion in 2015 will raise significant cash flow concerns. Thus, a phase-in approach may be more appropriate given budgetary constraints. However, delaying action only defers higher costs to future taxpayers and leaves less funding for school districts.

Figure 6: Recommendations for Financial Security of CalSTRS

Figure 7: Contributions as Percent of Payroll Required to Reach Full Funding in 30 years50

Incorrect assumptions, particularly regarding investment returns, arise frequently and can significantly alter the cost of providing benefits. Therefore, flexibility in contribution levels is essential to counter disparities between assumptions and reality. In fact, CalSTRS’s contribution levels have been inadequate for more than a decade (Figure 7) because the Legislature has failed to adjust contribution levels to match those required to achieve full funding in light of investment underperformance.52 Thus CalSTRS is unequipped to readily address its needs when assumptions are not met and required contributions change.

Therefore, we recommend that the Legislature regularly and systematically review actuarial valuations of CalSTRS’s financial health and adjust contribution levels to keep CalSTRS fully funded in the inevitable case that assumptions differ from the plan’s actual experience.

Conclusion

After enacted benefit increases and a decade of lackluster investment performance, CalSTRS has reached a point of financial crisis. Current contribution levels from members, school districts, and the state are inadequate to meet the future cost of benefit obligations, and it is highly unlikely that investment performance will make up the funding shortfall. Even if CalSTRS meets its ambitious 7.5% rate of return on investments over the long-term and even if the Legislature acts now, both of which appear unlikely, the fund will still need an initial contribution increase of $4.5 billion in 2015 and $240 billion over the next 30 years to regain full funding. If the Legislature makes no changes, CalSTRS will have no assets in 2043 or even sooner if investments continue to underperform.

At current contribution levels and assumptions, the unfunded pension obligation will grow by an average of $50 million each day for the next 30 years. As interest on debts compound, more and more of today’s costs are deferred – at substantially more expensive rates – to the next generations of Californians. The Legislature must take action immediately to fundamentally alter the fund’s financial trajectory and protect California’s school districts from a punishing downward spiral.

Works Cited [+ Expand][- Shrink]

1 Starting in 2015 requires an additional contribution that is 15.6% of payroll. Payroll is projected to be $28.7 billion in 2015. This equates to an additional contribution of $4.5 billion.

12 According to CalSTRS, “If investment returns had equaled the currently assumed rate of return of 7.5 percent since 2000, the DB Program would have had sufficient assets as of June 30, 2011, to fund 103 percent of its liabilities.” This hypothetical funding ratio is likely be higher as of June 30, 2012 valuation. CalSTRS. Sustaining Retirement Security for Future Generations: Funding the California State Teachers’ Retirement System. February 2013. Page 8.

13 This is the geometric average rate of return based on the historical market value, dollar weighted rate of returns from 2001-2012. These can be found in the Statement of Changes in Program Assets in the Actuarial Valuations performed for the fiscal years between 2001 and 2012.

According to the Public Pension Plans Database, an 88.4% funding ratio would place CalSTRS among the top 12 best funded public pension plans. To access the Public Pension Plan Database, consult the following: <http://pubplans.bc.edu/pls/apex/f?p=1988:20:27307747059090::NO:RP::> 17 This only includes contributions to the defined benefit (DB) plan.

24 With a 2013 start date, contributions under 5.1% return rate increase to 37% of payroll. In 2015, we estimate these increase to nearly 38%. The initial total and the sum was taken and multiplied by projected payroll from 2015 to 2044.

25 With a 2013 start date, contributions under 8.5% return rate increase to slightly over 7% of payroll. In 2015, we estimate this to increase to over 8%. The initial total and the sum was taken and multiplied by projected payroll from 2015 to 2044.

27 CalSTRS CEO Jack Ehnes stated, “Our estimates show that without contribution increases, CalSTRS would need to achieve 10 percent returns annually for the next 30 years to pay down the unfunded liability. Good returns at best merely slow a negative, downward trend.”

28 The rates chosen are not arbitrary. Milliman indicates in the 2012 Actuarial Valuation that 5.1% is the 25th percentile of return rates and 8.5% is the 75th. Milliman. California State Teachers’ Retirement System Defined Benefit Program 2012 Actuarial Valuation. Page 7.

32 CalSTRS states, “ Based upon legal analysis by outside counsel and an actuarial analysis, a guarantee of the 2 percent improvement factor would likely be determined to be a comparable advantage that permits an increase of up to 2.6 percentage points in the contribution rate paid by current members. (The actuarial analysis was based on a prior investment return assumption of 7.75 percent annually; given the current assumption of 7.5 percent, the maximum increase in contributions is now slightly higher.)”

34 According to the 2006 opinion of the state attorney general, much of this debate hinges on Section 41204, subdivision (c) of the California Education Code, which states: “Programs that existed in the 1986-87 fiscal year, and were not the functional responsibility of school districts or community college districts in that fiscal year, shall not be shifted to the responsibility or financial support of school districts or community college districts without appropriate corresponding adjustment to the calculations made pursuant to subdivision (b) of Section 8 of Article XVI of the California Constitution. . . .”

37 Ibid. CalSTRS states, “Resolution of outstanding legal issues should be attempted in order for the Legislature and the Governor to understand the true impacts of changes in contribution rate increases.”

38 These values include state only spending that has been budgeted for FY 2014.

42Note that this diagram is for illustrative purposes. There are currently no projections for 2015 school district general fund spending. Spending in 2015 may differ from 2012 levels and proportions. Also note that $4.5 billion will be less than 9% of school district general fund spending in 2015 if spending levels increase.

49 In accordance with government accounting standard practices, the benchmark time period for fully funding a pension fund is typically 30 years. However, the average duration of the CalSTRS obligation is roughly 14 years.

50 Current contribution levels are the average of those set in statute expected to be paid over the 30 years following the actuarial valuation date. The additional needed contribution levels are those needed in addition to current contribution levels that will fully fund the plan in the 30 years following the actuarial valuation date.

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